Q: I’m trying to figure out how much cash I should have in my portfolio. I have been told to have a six-month emergency reserve. Are there other reasons I should have cash?
A: When we talk about cash, we usually refer to money held at the bank in checking or savings accounts or held in certificates of deposit. Cash also refers to instruments like money market funds or treasury bills held in brokerage accounts or retirement plan accounts.
In an age of ultra-low interest rates, cash doesn’t get much respect. It isn’t sexy like stocks nor does it have the old-money charm of bonds. However, when used correctly, cash can play a very important role in a well-developed financial plan.
For example, no matter your age, it is wise to have an emergency cash reserve. The traditional rule of thumb is that your reserve should be equal to six months of basic living expenses. This emergency reserve helps you be resilient and gives you time to adjust to unforeseen changes in circumstances such as illness or accident.
In addition to your emergency reserve, it is good to build a reserve of cash to pay for the important purchases you expect to make in the coming 12 months. A cash reserve protects your important purchases from swings in the value of stocks or changes in interest rates. You will also find that the discipline required to plan ahead and maintain a reserve for your major purchases will help you avoid expensive consumer debt.
Cash also plays an important role in the management of investment portfolios. In general, the older we get, the more conservative our portfolios should be. For many people, this means reducing the swings in your portfolio’s value. Because cash has a very low correlation to most other asset classes, the volatility of your portfolio will decline in direct proportion with the amount of cash you hold. In other words, if you increase the cash in your portfolio by 10 percentage points, the volatility of your portfolio will decrease by 10 percent.
Portfolio cash can also help investors prepare for buying opportunities. I know several successful investors who carry cash balances in order to have “dry powder” if the market drops. They aren’t worried about the market and they aren’t trying to reduce risk. They simply recognize that the market ebbs and flows, and they feel better knowing they will have buying power when the inevitable ebb occurs.
Of course, holding cash brings its own risks. Being in cash means being out of the market. A recent JP Morgan showed that investors who stayed fully invested in the S&P 500 for the ten years ended December 2016, earned an annual return of 7.7 percent. However, investor who missed the ten best days of that decade only earned 4.0 percent. There is clearly a risk to being out of the market.
In addition, cash exposes the investor to inflation. Even low rates of annual inflation can add up to big headaches over time. For example, if annual inflation averages 2 percent, you will lose almost 20 percent of your cash savings in a ten-year period of time. The best protection against inflation? Staying invested in stocks.
Steven C. MerrellMBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to firstname.lastname@example.org.